|BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
|DIVISION OF BANKING
SUPERVISION AND REGULATION
March 28, 2002
Federal Reserve staff has become aware that in recent weeks bank holding companies seeking to hedge the interest rate risk on their issues of trust preferred stock have been offered derivative contracts with terms that have the effect of contravening the strict conditions for the inclusion of the trust preferred stock in tier 1 capital.1 The terms in question take effect when the bank holding company defers dividend payments on the trust preferred stock subject to the hedge. When such a deferral event occurs, the contracts provide that the derivative counterparty will defer on a cumulative basis its swap payments due to the banking organization while the bank holding company continues to make payments to the derivative counterparty. The Federal Reserve has supervisory concerns where the contract terms for deferral on swap payments are not symmetrical and require the banking organization to make payments to the swap counterparty without receiving payments from the counterparty. Contracts structured in this manner undermine the loss-absorbing capacity of the hedged trust preferred stock and, consequently, its eligibility for Tier 1 capital.
In order for trust preferred stock to be included in Tier 1 capital, the issuing bank holding company must have the ability to defer payments for at least twenty consecutive quarters without giving rise to an event of default. Such a deferral feature, which typically is cumulative in trust preferred stock, is essential in a Tier 1 instrument because it allows the issuer to conserve its cash resources at a time when its financial condition is deteriorating. Where an issue of trust preferred stock is hedged by a swap with asymmetrical deferral terms as described above, however, the cash resources conserved through deferral would be paid out to the swap counterparty. This outflow of cash would not be offset by receipt of payments in from the counterparty. Thus, such a contract defeats the cash-conserving purpose of the deferral mechanism on the trust preferred stock and undermines the instrument's loss-absorbing capacity.
Trust preferred stock issues that are covered by an interest rate derivative contract with asymmetrical terms such as those described above are not includable in Tier 1 capital. When a banking organization hedges trust preferred stock through an interest rate swap with a deferral feature, the deferral terms on the swap must be symmetrical for both the organization and its counterparty and must not have the effect of draining the organization's resources in a time of stress. A "plain vanilla" swap where neither the banking organization nor its counterparty may defer payments generally is an acceptable instrument for hedging the interest rate risk on trust preferred stock included in Tier 1.
Reserve Banks are asked to forward this SR letter to banking organizations subject to Federal Reserve supervision. Any banking organization that has hedged trust preferred stock with an interest rate derivative contract that is asymmetrical with regard to deferral terms should immediately contact its Reserve Bank. Any questions on this SR letter may be directed to Norah Barger, Deputy Associate Director, at (202) 452-2402, or John Connolly, Supervisory Financial Analyst, at (202) 452-3621.
Stephen C. Schemering
SR letters | 2002